The Fund Provider (Banks & NBFCs) boards only a creditworthy company’s debt funding ship. In fact, they board it only if they have assurance that the company’s boat won’t sink on its way to the shore. It (The Fund Provider) assesses in advance all the possible information that is needed; from how much fuel of capital is in the tank, to who is the captain of the ship. One of the most important tools for this assessment is the analysis of financial ratios of the company. A careful analysis is desired to know if funding the company is an opportunity or a threat. So, let us list these ratios and dig deeper into their significance.
Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity
It is also known as leverage ratio or capital structure. It mirrors how much financial risk the company has taken. A debt equity ratio greater than 1.5 shows a highly leveraged company.
Drawback of this ratio is that it includes operational liabilities in the total liabilities. These are account payables, pension obligation, deferred tax liability, etc.
Debt Service Coverage Ratio = Net Operating Income / Total Liabilities
This ratio shows whether a company is able to meet its debt obligations through its earnings from operations in a given year.
The ratio, if less than 1 signifies that there is insufficiency of cash flow within the company. This says that the company might be financially unhealthy and has a higher risk of defaulting. On the other hand, the company might be flexible in its finances and use fresh debt to cover for its existing debt obligations. This is the case for companies lying in their growth stage and require funds for their business needs.
Current Ratio = Current Assets / Current Liabilities
It signifies a company’s financial power to meet its current or short term obligations. It judges the liquidity within a company. The higher this ratio, the better it is for the company.
Quick Ratio = Cash & Cash Equivalents + Short-Term Investments + Account Receivables / Current Liabilities
It is another indicator of liquidity within a company. It is way more accurate than current ratio as it eliminates assets like inventories which are difficult to convert into cash. Due to its conservative nature, it is also called the acid test ratio.
Gross Profit Margin = Gross Profit / Net Sales
Gross profit is calculated by subtracting cost of goods sold from the net profit earned. The ratio measures earnings of the company after excluding the cost of goods sold i.e. how well the company can convert its raw materials to revenue.
Operating Profit Margin = Operating Profit / Net Sales
The operating profit margin shows how much a company earns on each rupee of net sales. It helps in showing a clear picture of the operating efficiency of the company. The company with a high operating profit margin is profitable in its operations.
Net Profit Margin = Net Profit / Net Sales
The net profit margin of a company signifies the overall profitability of the company after deducting all the costs to the company.
Return on Assets = Net profit / Total Assets
This ratio signifies to what extent are the assets of the company useful in generating revenues.
The above are the few important ratios that are calculated to project a company’s financial position and performance. Looking at just one ratio can be misleading. Hence it is advisable to reach conclusions only after analyzing all of them with great care.